Treasury Prices Fall on Budget Deal Hopes

U.S. Treasurys prices fell on Monday as greater optimism lawmakers in Washington will reach a deal to avert a fiscal crunch reduced demand for safe haven debt.

U.S. President Barack Obama and Republican Speaker of the House of Representatives John Boehner were meetingat the White House on Monday to discuss how to resolve the "fiscal cliff."

Over the weekend, Boehner proposed an increase in taxes that, while still far short of what Obama is seeking, represented the first real movement in negotiations ahead of a Dec. 31 deadline. (Read More: See Complete Coverage of the Fiscal Cliff)

"The market is in general anticipating some sort of deal out of Washington before the holiday week," said Greg Faranello, a Treasurys trader at Societe Generale in New York.

The Treasury sold $35 billion in two-year notes to lukewarm demand, with the notes selling at a high yield of 0.245 percent, around 1 basis point higher than where the debt was trading before the auction.

Indirect bidders, that often include foreign buyers, took the smallest portion of the sale since February 2008 at 17.7 percent, and dealers took 53.9 percent, the most since September.

The government will sell an additional $35 billion in five-year notes on Tuesday, $29 billion in seven-year notes on Wednesday and $14 billion in five-year Treasury Inflation-Protected Securities (TIPS) on Thursday.

Interest rates on some U.S. one-month Treasury bills turned negative on Monday on strong demand fed by expectations that the Transaction Account Guarantee (TAG) program that protects large bank accounts will not be renewed by the end of the year.

Analysts expect that the expiration of the program may result in hundreds of billions in assets being transferred to money market funds, which are then likely to increase their investment in short-term government bills.

Year-end hoarding of cash and nagging worries about a possible fiscal crisis in Washington have also fed the purchases of Treasury bills in recent weeks, helping the Treasury on Monday sell new three-month and six-month bills at the lowest rates in almost a year.

Inflation expectations as measured by five-year Treasury Inflation-Protected Securities (TIPS) fell, though stayed near their recent highs as investors expect the Federal Reserve will tolerate higher inflation, after it said it will make new Treasurys purchases in a bid to stimulate the economy.

The Fed said last week it would keep interest rates near zero until the jobless rate falls to 6.5 percent, as long as inflation does not threaten to break above 2.5 percent and inflation expectations are contained.

"The Fed has pushed higher the lid on inflation tolerance, its bullish for TIPS" said Carlos Pro, an interest rate strategist at Credit Suisse in New York.

Expectations that inflation may rise at a faster pace may help demand for TIPS in Thursday's auction, though the debt may also be volatile heading into year-end as many investors close their books for the year.

"A lot of people are done for the year, they don't want to put on a lot of risk," said Pro.

Five-year TIPS breakevens traded on Monday at 2.20 percent, down from a two-month high of 2.22 percent last week after the Fed's statement, but above the 2.18 percent area the debt had traded at before the statement.

The Fed bought $4.90 billion in Treasurys due 2019 and 2020 on Monday as part of Operation Twist, which involves buying long-dated debt and funding the purchases with sales of short-dated notes.

It will buy up to $2.25 billion each day this week in long-dated debt as part of this program.

U.S. Treasury data on Monday also showed that China and Japan both added to their Treasurys position in October.

China, the largest foreign U.S. creditor, increased its Treasury holdings by $7.9 billion to $1.162 trillion. Japan, the second largest foreign holder, bought $5.2 billion in October, bringing its total to $1.135 trillion.